The ESG challenge for REAL ESTATE
ESG challenges for the real estate industry
The real estate market, as all other markets, has been shaken by the implementation of new regulations in terms of sustainability such as the Sustainable Finance Disclosure Regulation (SFDR), as well as by the different climate and energy crises impacting the world.
To provide context, the SFDR regulation applies to Financial Market Participants (FMPs) and Financial Market Advisors (FMAs) whose business or operations are performed in the European Union.
Originally, SFDR was primarily designed to improve transparency through disclosures and reporting for sustainable finance activities but it was mainly addressing and scoping the public equities market. However, its scope has been extended to private markets such as the one for real estate.
To fulfill SFDR requirements, the FMPs have to assess their financial products’ exposure to sustainability risks (Art.6), whether or not its promoting ESG characteristics (Art.8), its consideration of PAI and/or its positive contribution to an environmental objective (Art.9).
Although it only represents approximately 3% of total financial capital, the real estate market accounts for 39% of total CO2 emissions and 36% of energy use. Thus the objective of the EU Action Plan on Sustainable Finance to redirect capital towards sustainable investment is affecting the real estate market more than any other.
Thankfully, they haven’t waited for the regulation to tackle the challenge of reducing its emissions and minimising its resource efficiency. This exercise of transparency could appear "easier" for real estate products, which are, by nature and through their different certifications and standards, already collecting data in terms of CO2 emissions and resources efficiency, among others. Nevertheless, it still remains to be seen how the real estate industry can align with a regulation that primarily addresses public equities and doesn’t necessarily consider the specificities of a potential transition to net zero for this industry.
The real estate industry’s reaction to the regulation
The entire financial market has been shaken by the clarification of the ESMA JC 2022 62 from November 2022 which has made it clear that 100% of the assets under an Art.9 fund must already be sustainable. The objective of an Art.9 is to cover products which have a “positive impact”, even if it’s not clearly expressed, and to identify the products that invest capital in sustainable investments.
This objective has been welcomed by the market and is more than a necessity. We also see that the alternatives market, and the real estate and infrastructure markets in particular, are trying to define strategies that seek to maximise resource efficiency and minimise emissions.
However, this is also creating a lot of confusion as we are seeing Art.8 funds undertaking a strategy which excludes assets based on an exclusion policy to assets that consider the Principal Adverse Impacts and/or which have an objective of transformation to decarbonisation. As a result, most real estate assets with either a positive impact or a sustainable investment objective are left to the side and placed in the same category as real estate assets that have less or no ESG ambitions. Considering that investments in real estate are mainly done over a medium to long term period of time, another issue has come up where investments in new buildings are favoured at the expense of transformation projects and could ultimately affect the objective to reach net zero. Aymeric de Sérésin (Lead Portfolio Manager at Fidelity International) recently pointed out that “at least 80% of the real estate stock is still far from where it should be to meet the expectations of the Paris Agreement. Commercial real estate stock is particularly affected. But that's not all. Our industry is quite slow, and we see barely 1% of the real estate stock being renovated each year. If we continue on this trajectory, there is a risk of missing the goals of the Paris Agreement by 2050."
The different real estate ESG frameworks
The other question that often comes up is how the current strategies that design and implement resource efficiency and emission reduction often validated by several certifications such as BREAM, LEED, CREEM, or WELL for the social aspects can be easily integrated into the SFDR classification of an Art.8 (promotion of ESG characteristics) or of an Art.9 (positive contribution to an objective).
We can certainly make a link between all these certifications and SFDR and leverage their respective results in relation to Article 8 as their requirements (KPIs assessed and scope) are intrinsically similar in terms of promotion of ESG good practices.
However, regardless of their scope (entity or asset level), these certifications will only help fund managers collect some KPIs. They can also help, at maximum, to define thresholds respective to their strategy. In any case, it will not be sufficient to get certifications to classify financial products under Art.8 or 9 of SFDR. Nevertheless, these certifications are the perfect vehicle to set up ESG good practices, which aim at preserving the value of real estate investment.
What the recent studies of the real estate market have demonstrated* (name INREV) is that institutional investors now request Art.8 as a prerequisite for investing in real estate products. We also see that the number of real estate products classified under Art.8 has reached around 39% compared to 3% Art.9.
In this regard, the regulation has reached its objective to push capital towards more sustainability.
However none of these certifications cover the so-called double materiality concept that takes into consideration the impacts on the people and the planet. Therefore, they are not always fully aligned with the Paris Agreement and its commitment towards reduction of global emissions to limit global warming to well below 2 degrees.
They all allow for the calculation of its emissions reduction and resource efficiency maximisation but none of them, unlike the EU Taxonomy or scientific initiatives such as SBTi, allow for the calculation of its positive impact on the planet. This does not enable an industry that generates 38% of global emissions to put in place a pathway to achieve a decarbonised world while creating value.
ESG frameworks as value creation catalysts
In a nutshell, all of these certifications are incredible value-preserving tools that allow you to contain your reputational risks, but also minimise your operational costs in terms of energy efficiency, ensuring better performance and retention of your tenants. However, it has been shown that the implementation of good practices only allows the preservation of value, whereas providing a positive impact is value-generating.
Value creation can only be achieved by demonstrating that an asset has a positive impact on the planet or people through either i) Taxonomy alignment, or ii) by demonstrating its positive contribution while limiting its negative impacts on all externalities and respecting social and good governance standards (Labour & Human rights, Taxation, Bribery & Fair competition). This definition is clearly defined by the European Union Commission under SFDR art.2(17).
Conclusion
The regulation and particularly SFDR focus on sustainable investments objectives without taking into consideration "transitional sustainable strategies" with the ambition and progress of transitioning to net zero.
As we know, the real estate industry usually invests in the medium to long term and with 38% of the global emissions and 36% of the energy use, the industry is facing a huge challenge in the transition to net zero.
The current regulatory landscape doesn’t favour real estate assets that design and implement strategies that seek to maximise resource efficiency and minimise emissions through transition. The regulation should rapidly ensure that investment capital is placed towards assets with transition strategies if it wants to ensure that the real estate industry participates in the transformation towards a decarbonised world while creating value.
References:
- INREV Member Briefing - Paper Professional Standards
- Falling through the cracks: SFDR’s impact on real estate investment
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